Taiwan banks challenged by post-Tarf loss regulations

Crackdown on "high risk" derivative products drives up dealers' costs

Dealers are complaining that the latest regulation governing complex derivatives transactions in Taiwan following large-scale losses in 2014 on target redemption forwards (Tarfs) by local corporates is driving up transaction costs and limiting their ability to sell investment products.

Taiwan corporates faced unrealised losses of 6 billion Taiwan dollars ($150 million) in the first quarter of last year after a sharp reversal of the renminbi against the US dollar left their Tarf positions well out of the money, according to local regulator, the Financial Services Commission.

As a result the FSC launched a crackdown on the sale of RMB-linked Tarfs, and on June 2 the regulator took further steps to regulate what it terms "high risk" derivatives products. Market participants say the new regulations will require massive upfront infrastructure investment, further squeezing profit margins which have been challenged since the Tarf issue first emerged.

A prominent provision of the regulation is requiring banks to add a "loss limit" on each product traded with clients. It is applicable to structured products consisting of three or more options linked to foreign exchange, interest rates, equity, credit, indexes or commodities.

While the FSC does not specify the level of the cap, most banks have started implementing a 30% cap on losses for Tarf products, meaning firms cannot lose more than 30% of the notional value.

"It increases the cost of issuing Tarfs, as the stop-loss term reduces profit margins, but banks cannot simply shift the cost to clients as they need to maintain an attractive pricing amid intense competition," says Tony Kao, Taipei-based head of sales at Cathay United Bank.

In fact, some large Taiwanese banks have traded Tarfs with capped loss since last September, when the draft regulation was still being reviewed. However, from June 2, banks were compelled to do so by regulators; previously such an approach was optional, says an official from the FSC in Taipei.

Kao says the Tarfs with capped loss reduce banks' profit by 5% to 10%, depending on the underlying or tenor as well as other conditions.

The FSC has also set out a 30% capped loss limit on other exotic forex derivatives, such as pivots, discrete knock-outs and American knock-outs, which are popular alternatives in Taiwan after the regulator tightened the sales of Tarfs.

Both types of knock-outs are forwards which terminate once a predetermined point is breached. Similarly, a pivot sets out support and resistance levels on the exchange rate of pair currencies and the contract will be terminated when they move out of this range.

In addition, the FSC has increased its focus on how banks sell complex derivatives by, for example, calculating and monitoring the concentration risk faced by clients. While the FSC does not stipulate specific concentration levels, Kao says a common standard is 70%: meaning the notional value of complex derivatives transactions must not be higher than 70% of the client's overall risk-weighted assets.

The regulator also requires voice recording of dealing process to provide evidence that the transaction is intended for hedging purposes, because such deals are exempt from the new standards which only govern trades for investment purposes, says the FSC official.

"All of these need a thorough upgrading of banks' trading and risk management systems. We must put more people, money and time into the business than before. The high compliance cost weakens banks' profitability," says Larry Hsu, Taipei-based head of global capital markets at CTBC Bank.

Kao says that because of the new rules, Cathay United Bank has built up three separate systems – one for the customer management system, another for booking and a separate piece of portfolio management infrastructure – in order to satisfy the FSC's requirements.

"You have to do it all electronically – clients' credit lines, trading status, margin, mark-to-market value and simulated maximum losses ... otherwise it's impossible to meet these complicated rules. The upfront investment on the infrastructure is massive," he says.

As a result, Taiwan banks' revenue from derivatives transactions saw a major fall in the first half of 2015, according to market sources, with two major Taiwanese banks saying their trading volumes of Tarfs in the first six months fell by 30% compared with figures in the same period of 2014.

"On one hand, some investors haven't re-entered into the market after the Tarf event. On the other hand, the new rules substantially increase banks' trading cost. Both aspects resulted in the decline of the revenues from derivatives business," says Hsu at CTBC Bank.

For global banks operating in Taiwan the issue is less acute. While they must also embed stop-losses in structures when they conduct back-to-back trades with local banks, Eric Chien, Taipei-based head of global market at Crédit Agricole, says the impact of this is limited.

"Tarf is a major product marketed by many Taiwanese banks so the crackdown on it has a significant impact on local banks' income, but global banks have more diversified product lines and exotic forex derivatives like Tarf only make up a fraction of our offerings."

Following the FSC framework, the Bankers Association of Taiwan is formulating a supplementary rule that will streamline the methodology of calculating value and risk of "high risk" derivatives products. The rule is expected to be introduced in July, according to the FSC official.